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Monday, November 17, 2014

Evaluating Reasons to Avoid Index Funds

It’s important to read books and articles that make arguments that are at odds with your current thinking once in a while. Understanding counter-arguments is a good way to make sure your reasoning is sound. After all, I would never have stopped stock-picking if I hadn’t read about indexing with an open mind. With that in mind, I read an Investopedia article entitled “5 Reasons to Avoid Index Funds.” Here I go through the arguments made in this article.

1. Lack of Downside Protection

It’s true that index portfolios do not prevent short-term losses. Just think of how much more money you could make if you could always trade out of stocks that were about to drop. The Investopedia article points to several strategies for making money when you know the market will drop. The problem is that you don’t know when the market will drop. As a matter of fact, most of the time that investors try to time the market, they end up making less than if they had just stayed invested in the index the whole time. This applies not only to retail investors but to professionals as well. Just riding out market downturns with mechanical portfolio rebalancing beats investor judgement over the long run.2. Lack of Reactive Ability

If you could tell when certain stocks are under- or over-valued, you could certainly beat the index. Unfortunately, there is no evidence that anyone can do this consistently. Every so often a star money manager makes good moves for a few years, but they almost always come crashing back down to earth.

3. No Control Over Holdings

It’s true that the index contains all stocks including companies you may not want to own for moral or other reasons. Some investors believe they can identify poor companies they prefer not to own. All the evidence says that the vast majority of investors cannot consistently choose winning stocks. But if you’re determined to avoid certain stocks despite the fact that doing so will likely lose you money, then indexing is not for you.4. Limited Exposure to Different Strategies

The Investopedia article says “there are countless strategies that investors have used with success.” There are even more strategies investors have used that led to failure. Jumping around between different strategies is often harmful to returns. So often they see their holdings decline in value and jump to shiny new stocks that have performed well lately. Unfortunately, you can’t capture past stock returns. Recent strong performers often stumble. Constantly jumping from losers to recent winners is a formula for losing money.

5. Dampened Personal Satisfaction

It’s certainly true that some people enjoy the “satisfaction and excitement” that comes with using their own judgement to make stock picks. But this satisfaction and excitement can give way to pain when investors take big risks and lose big. This can be more than just the pain of losing money; it is painful to the ego to have your overconfidence stomped by reality. This overconfidence can lead investors to take wild chances. Stock indexes sometimes drop significantly, but they have always recovered eventually. This is not true for individual companies. Some stocks go to zero and this can permanently damage a concentrated portfolio. I prefer to find my challenges and excitement in activities other than stock-picking.

Overall, I found the article disappointing. I would have preferred to learn something new that challenges my current thinking.

In a recent column, Dan Solin suggested that passive funds are the gold standard because passive fund managers can screen out stocks like IPOs and maybe historically poor performers like airlines. What's going on here? Is this the case of index investors trying to have a little taste of active management and not wanting to settle for mere market returns?

@Robb: Dan Solin has connections to the BAM Alliance, Buckingham, and Dimensional Fund Advisors. Dimensional takes a very academic approach based on indexing. However, they also try to optimize in ways that, depending on your taste, introduce active elements. Perhaps this is what Dan was talking about. I can certainly see how standard broad indexing would exclude IPOs until they had been around for a few years, but I don't see how they would exclude airlines without adding an active element.

Your writings on using the MERQ as a better measure of the impact of costs on a portfolio came to mind when I read this. Even if an active management strategy has some possible merit or advantage over passive indexing, the comparatively high MER charged to provide that strategy to an individual investor may ultimately far outweigh any perceived advantage.